Yearend Tax Planning Update

As the end of the year approaches, here are a few things that you will want to be aware of:

2013 Inflation-adjusted Amounts: The IRS released a number of inflation-adjusted tax amounts for 2013 including, for example: (1) the amount used to reduce the net unearned income reported on a child’s return that is subject to the “kiddie tax” increases from $950 to $1,000; (2) the annual exclusion for gifts rises from $13,000 to $14,000; and (3) the foreign earned income exclusion goes from $95,100 to $97,600.

2013 Pension Plan Amounts: The IRS published cost-of-living adjustments to various pension plans and related amounts for 2013. For instance, the (1) benefit limit for defined benefit plans increases from $200,000 to $205,000; (2) defined contribution plan limit goes from $50,000 to $51,000; (3) compensation limit for determining benefits and contributions increases from $250,000 to $255,000; (4) definition of a highly-compensated employee is unchanged at $115,000; (5) elective deferral limit for employees who participate in 401(k), 403(b), and most 457 plans goes from $17,000 to $17,500; and (6) limit on contributions to SIMPLE accounts increases from $11,500 to $12,000.

Closing Agreements: The IRS explained in Chief Counsel Advice that if subsequently effective regulations change or modify the law regarding an issue covered in a closing agreement, the agreement will no longer be binding for that issue. The IRS can require the taxpayer to comply with the changed or modified law, and an IRC Sec. 481 adjustment would be calculated to take into account the taxpayer’s prior position with regard to the issue in earlier years.

Private Sector PTIN Directories: The IRS Issue Management Resolution System (IMRS) captures, develops, and responds to significant stakeholder issues. In a recent IMRS Hot Issue, the IRS noted that directories have been set up on the Internet using Preparer Tax Identification Numbers (PTINs) obtained from the IRS through the Freedom of Information Act (FOIA). Businesses have the right to obtain the listing via FOIA “and attempt to monetize it through business ventures.” The IRS cannot restrict these activities. The IRS is creating a publicly searchable database that will allow taxpayers to see if their tax preparer meets IRS standards or to find a tax preparer in their zip code area. This database will have a listing of all valid PTIN holders who have professional credentials (CPAs, enrolled agents, attorneys, and registered tax return preparers) and will be available around May 2013.

Social Security Wage Base for 2013: In 2013, the first $113,700 of wages or SE income (up from $110,100 in 2012) will be subject to the Social Security component of the FICA tax. Once again, there will be no limit on the wages or SE income subject to the Medicare component of the tax. Assuming that the Social Security payroll tax cut in effect during 2011 and 2012 is not extended, employees and employers will each pay a FICA tax rate of 7.65% in 2013 (Social Security tax rate of 6.2% plus the Medicare tax rate of 1.45%) while the self-employed will face a combined tax rate of 15.3%. To add another layer of complexity, beginning in 2013, the employee portion of the Medicare tax increases from 1.45% to 2.35% on wages (and SE income) in excess of $200,000 ($250,000 for MFJ and $125,000 for MFS).

Estate Tax—Statistics for 2010: According to a recent IRS Tax Stats Dispatch, less than half the estates that filed an estate tax return for 2010 owed tax with roughly 20% of estates claiming a charitable bequest deduction. Due primarily to increases in the filing threshold, the number of estate tax return filings decreased from more than 108,000 in 2001 to just over 15,000 in 2010.

Income Tax—Bankruptcy Exemption for Retirement Account: A state divorce court awarded an ex-wife 50 percent of her ex-husband’s 401(k) account and ordered him to pay her $43,500 of the equity in one of the houses they owned. His failure to pay the home equity amount on time resulted in that money also being removed from his 401(k). The ex-wife placed the funds in a newly established IRA. A month after opening the IRA, she filed for Chapter 7 bankruptcy. The District Court denied a bankruptcy exemption for the home equity payment because the money had been seized from a 401(k) and used to pay a debt the husband owed; thus, it no longer constituted retirement funds.

Income Tax—Business Sale: The taxpayer owned and operated an insurance business in Harvey, North Dakota, a town of a couple thousand residents where fewer people moved in during a given year than died or moved away. The insurance market was very competitive with several independent agents in the area, but the taxpayer was the most well known. Eventually, he sold his business and began employment with a local bank that wanted to revive its insurance business. In addition to six annual installment payments of $20,000 for files, customer lists, and goodwill, the employment agreement specified a six-year deal with annual wages and deferred compensation. The Tax Court held that the wages paid were not disguised purchase-price payments because the two parties were genuinely interested in creating an employment relationship and not simply affecting tax consequences. The bank needed an experienced manager, and the taxpayer wanted guaranteed employment.

Income Tax—Deductible Restitution Payments: Taxpayers who repay embezzled funds are ordinarily entitled to a deduction in the year in which the funds are repaid. In a Private Letter Ruling, the IRS allowed a doctor to deduct restitution payments made to an insurance company in a criminal lawsuit for insurance fraud. In addition, restitution payments made to the state of New Jersey, in exchange for the dismissal of charges in its suit against the taxpayer, were deductible if no contributions from another party (i.e., the other doctor and practices that had been sued) were received and the amounts had been included in gross income in prior years.

Income Tax—ESOP’s Exempt Status Revoked: A highly-compensated employee must include, in gross income, an amount equal to his vested accrued benefit (other than the investment in the contract) in the taxable year an ESOP ends if the trust fails to remain tax-exempt because it no longer meets certain coverage and eligibility tests. In this case, the taxpayer’s S corporation sponsored an ESOP in which the taxpayer had an accrued benefit of $2.4 million. When the ESOP terminated, taxpayer’s entire account balance was transferred to an IRA. The IRS retroactively disqualified the ESOP as tax-exempt as a result of its failure to meet certain coverage and participation requirements. The limitations period for assessment had expired for all years except the year the ESOP was terminated. The Tax Court held that the entire amount of the taxpayer’s vested accrued benefit had to be included in income and not just the annual increase in the final year of the ESOP.

Income Tax—End of Filing Season Considerations: With the end of another filing season, the IRS has included a timely link entitled “After You’ve Filed” as one of the five scrolling topics on the homepage of www.irs.gov. In the information provided, the IRS reminds taxpayers that (1) the refund status of an e-filed return can be checked 72 hours after the IRS acknowledges receipt, (2) those who moved after filing their return should send Form 8822 (Change of Address) to the IRS, (3) the IRS’s online withholding calculator is a useful tool to assist employees in completing or adjusting Form W-4 (Employee’s Withholding Allowance Certificate), and (4) copies of prior year tax returns or transcripts, which include most of the line-items of a return, are available by filing Form 4506.

Income Tax—Filing Guidance for Same-sex Couples: Although the Obama administration no longer defends the Defense of Marriage Act (DOMA) and several courts have struck down key provisions, the IRS continues to defer to DOMA in its guidance to same-sex couples. The most recent guidance is provided in question and answer format. The guidance states, in part, that (1) same-sex couples, who are legally married for state law purposes, may not file as MFJ or MFS; (2) a taxpayer cannot file as HOH based solely on his or her same-sex partner; (3) either parent, but not both, may claim a dependency deduction for a qualifying child; (4) if a same-sex couple adopts a child together, each partner may claim the adoption credit in an amount equal to the qualified expenses paid, but both may not claim a credit for the same expenses or claim more than the amount he or she actually paid; and (5) if a taxpayer adopts the child of his or her same-sex partner, the taxpayer may claim an adoption credit for the qualifying expenses.

Income Tax—Involuntary Conversions: The taxpayer’s principal residence was destroyed in a presidentially declared disaster. Upon acquiring a new principal residence the next year, he failed to notify the IRS of the replacement property, as required under Reg. 1.1033(a)-2(c)(2) . He received insurance proceeds in the year of the disaster and in the following two years. In the second year, the taxpayer realized gain when the insurance proceeds exceeded his basis in the former residence, but he did not report any gain recognition. The IRS held that under the regulations, the taxpayer was deemed to have made the election to defer gain under IRC Sec. 1033 when he did not recognize gain on his tax return in the year he received insurance proceeds.

Income Tax—IRA Rollover Waiver: The taxpayer and his investment partner purchased a residential building with a mortgage and promissory note. Years later, they entered into an agreement to sell the property. But, in order to complete the sale, the promissory note had to be paid off. Unable to find a lender and faced with foreclosure if the note was not paid off by a certain date, the taxpayers withdrew money from their IRAs to pay off the note. Although delays in closing the sale extended repayment of the withdrawn funds for several months, the IRS declined to waive the 60-day rollover requirement under IRC Sec. 408(d)(3) . Taxpayers did not show that the failure resulted from (1) errors committed by a financial institution, (2) death, (3) hospitalization, (4) postal error, (5) incarceration, and/or (6) disability.

Income Tax—SIFL Rates for Employer-provided Aircraft: Under Reg. 1.61-21(g), employers can use a special computation rule to value employees’ flights on an employer-provided aircraft. The employer multiplies the Standard Industry Fare Level (SIFL) cents-per-mile rate in effect at the time of the flight by the appropriate aircraft multiple provided then adds the applicable terminal charge. For flights taken from 7/1/12–12/31/12, the SIFL rate will be $.2569 per mile for trips up to 500 miles, $.1959 per mile for trips from 501 to 1,500 miles, and $.1884 per mile for trips over 1,500 miles. The terminal charge will be $46.97.

Procedure—Penalty Abatement: It is common for the IRS to waive Failure to File (FTF) and Failure to Pay (FTP) penalties for taxpayers who have demonstrated full compliance over the prior three years. This waiver, called a First-Time Abate (FTA) is to reward past tax compliance and promote future tax compliance. A report by the Treasury Inspector General for Tax Administration (TIGTA) found that most taxpayers with compliant tax histories are not offered and do not receive the FTA waiver. For the 2010 tax year, approximately 250,000 taxpayers with FTF penalties and 1.2 million taxpayers with FTP penalties did not receive penalty relief even though they qualified for the FTA waiver. In addition, taxpayer requests for penalty abatements were not always processed accurately.

Procedure—Tax Return Preparer E-file Requirement: According to a posting to the IRS Issue Management Resolution System (IMRS) Hot Issue webpage, any tax return preparer who anticipates preparing and filing 11 or more Form 1040, 1040A, 1040EZ and 1041 returns during a calendar year must use IRS e-file (unless the preparer or return is administratively exempt from the e-file requirement or the return is filed by a preparer with an approved hardship waiver). Effective 10/1/12, applications to become an IRS e-file provider must be submitted online. The IRS will no longer accept paper e-file applications.